Maxing Out Your 401(k) and Investing Beyond

Close up of a 401(k) statement

Ushered in as part of the Revenue Act of 1978, the original intent of the Internal Revenue Code, Section 401(k) was to afford employees an opportunity to defer the tax liability of bonuses and stock options. This evolved into what we know today as the defined contribution retirement plan, commonly referred to as a 401(k). Named after the section of the IRS code responsible for their creation, these plans offer a number of significant financial benefits, which makes maxing out your 401(k) a good idea. Once you’ve maxed out your 401(k) if you have additional funds on hand, you may also want to invest beyond your 401(k).

How a 401(k) Works

Under a 401(k) retirement savings and investing plan, rather than providing and managing pensions for workers, employers shifted to a strategy in which employees contribute part of their current earnings to their own retirement plans before they’re taxed. The money is deducted from paychecks automatically.

This approach shifted the onus of retirement funding from the employer to the employee — although some employers do match the funds an employee sets aside up to a percentage of their choosing. The maximum allowed annual contribution for the 2022 tax year, as determined by the IRS, is $20,500 for workers under the age of 50 and $27,000 for those 50 and over. The amount tends to change on an annual basis to keep pace with inflation. These figures mark a $500 increase over 2021.

Investing these funds permits them to grow free of taxation — until they are withdrawn. This tax-deferred status holds true for interest, dividends and any other form of investment gain derived from investments in the 401(k) plan. 

Financial experts consider a 401(k) one of the “three legs” supporting the stool that is your retirement – the others are Social Security and personal savings/investments.

Managing a 401(k)

Taking advantage of the 401(k) plan is smart in general, but especially so when your employer offers matching funds. Writing for Forbes, retirement plan consultant Robert Lawton says the basic rule of thumb is to add 15% of your pre-tax pay to your plan each year — including your employer match. 

In other words, if your employer offers a match of up to three percent of your annual salary, you’ll need to contribute 12% to hit the 15% mark. If that feels a bit steep right now because of other obligations, aim to start where you can and increase it by one or two percent each year. In fact, in an interview with CNBC, certified financial planner and founder of Delancey Wealth Management, Ivory Johnson, recommends increasing your contribution rate as you get pay raises until you max out your contribution.

The key is to start contributing at the beginning of your career and maxing out your 401(k). Otherwise, as time goes on and you get closer to retirement, you’re going to see you need more money. This is when many people start backloading their plans. Meanwhile, they’ve missed out on all of the gains they could have experienced from compounding over the years had they been maxing out their 401(k). 

When it comes to managing your plan, Lawton recommends:

1. Contribute at least 15% of your annual salary each year

2. Continue contributing until the fund matures

3. Collect all available matching funds

4. Keep a portion of your savings in a Roth 401(k)

5. Seek professional investment help

6. Allocate your balance to target date funds

7. Do NOT sell your investments

8. Don’t borrow against the account

9. Don’t roll 401(k) funds into an IRA (more on this below)

Withdrawing 401(k) Funds

Because the funds comprising a 401(k) account are diverted before being taxed, you’ll incur a tax liability when you withdraw them. Moreover, as the basic idea of the 401(k) savings and investment plan is to put money away for your retirement years, a 10% penalty is imposed in addition to the taxes to discourage premature withdrawal — under certain circumstances. 

The primary 401(k) withdrawal methods include:

• Retirement disbursements – made after the age of 59.5.

• Early withdrawals – prior to age 59.5 can carry a 10% penalty

• Hardship disbursements – for emergency needs, can also carry the penalty 

• Personal loans – permitted with no penalty if repaid on time

• Rollover – you have 60 days to move the money if you change jobs

Mandatory disbursement – minimum distributions are required at age 72.

However, you can take money free of the 10% penalty from the account you had with your previous employer if you change employers at 55 years of age. Permanent disability also qualifies you for penalty-free disbursements. Medical expenses in excess of a qualifying percentage of your adjusted gross income can be settled with penalty-free dollars from your 401(k) account too. And, should you and your spouse divorce; the account can be split between the two of you without incurring the penalty — assuming the funds are subsequently rolled into a similar 401(k) plan.

Hardship withdrawals can also include:

1. Buying a home

2. Making tuition payments for the account holder or dependents 

3. Eviction or foreclosure prevention

4. Funeral expenses for the account holder, spouse or dependents. 

Again though, these withdrawals may be subject to the 10% penalty, unless they fit within the parameters of the exemptions listed above.

Borrowing Against Your 401(k)

Many plans permit the borrowing of up to 50% of a 401(k) account’s vested balance, or a maximum of $50,000 within any given period of 12 consecutive months. The loans work much the same as any traditional loan, except you’re borrowing from yourself — and repaying yourself — with interest. All is well as long as you repay according to the loan agreement. Otherwise the 10% penalty comes into play. 

Rolling Your 401(k) Over

In the event of the loss of a job for any reason, or should your plan terminate, the funds can be moved to another retirement account operating under the same rules. This can be accomplished either by a direct rollover (the money is automatically transferred from one account to another), or an indirect transfer in which the funds are disbursed to you and you’re tasked with depositing them in the new account within 60 days. And yes, the penalty will kick in if you fail to do so within the time frame allowed. 

Job Changes

Your choices when moving to a new job are to let your account stay with the previous employer, open an IRA (which experts discourage), or deposit it into the new employer’s plan. Each of these options can be accomplished without incurring the penalty (more or less – we’ll explain below). You can also choose to cash out altogether, which, depending upon your age at the time, could trigger the penalty along with the corresponding tax liability. 

The IRA Option

Moving your 401(k) into an Individual Retirement Account (IRA) can be done without encountering taxes or penalties. That is, assuming you have a traditional 401(k) and move into a traditional IRA. You also have the choice of conducting a Roth conversion, although doing so will trigger tax liability because taxes on a Roth IRA are paid up front, as opposed to at withdrawal. 

There are some other drawbacks to migrating to a standard IRA of which you should be aware. These include the advisory charges you’ll encounter to have someone manage the account, as well as the fact that investment options are typically more expensive with an IRA. Money that could be earning interest for you will be siphoned off in fees. 

Calculating Your Retirement Payout

As with so many other things mathematical, your results will vary based upon the various elements of a given equation. In the case of a 401(k) retirement plan, the best two things you can do to ensure an above average result is start early and be consistent.  

One of the best 401(k) calculators we’ve found is at the Nerdwallet site and bears this out. To use it, the factors you’ll need to determine your position at a given retirement age are your contribution amount, employer match, anticipated age of retirement, current age and the expected rate of return of your investment package. 

When you play around with the calculator, or if you’re familiar with compounding interest, one takeaway is abundantly clear — the earlier you start, the more time your money will have to earn you a return — and allow that money to earn a return as well. So, the sooner you start, the more affluent you’ll be in retirement if you’re consistent.

As an example, let’s say you’re just getting started at 47 years old, you’re earning $85k annually, you expect to retire at 67 and live to 95. You contribute $853 monthly, which is 12 percent of your salary. Your employer matches it at 50 percent of your contribution up to 6%, which works out to be 15% of your pre-tax salary. And, let’s say you invest in an index fund that returns an average of 10% annually.  

According to the Nerdwallet calculator, your account will be worth $1.27M at retirement after 20 years. This works out to a disbursement of $2,575 monthly over the 28 years between your retirement and your 95th birthday. 

Now, let’s say you start at age 22 and all other parameters remain constant. You’ll have an $18.6m balance at retirement and a monthly payout of $22,967 — thanks to the power of compounding interest.

The takeaway here — the sooner you start, the more affluent you’ll be in retirement if you’re consistent.

Average 401(k) Balance by Age

This is a lesson that’s been lost on a lot of people. The average 401(k) balance was $106,478 in 2020, according to a Business Insider report. The median balance is $22,775. 

AgeAverage balanceMedian balance
Under 25$5,419$1,817
25 to 34$26,839$10,402
35 to 44$72,578$26,188
45 to 54$135,777$46,363
55 to 64$197,322$69,097
65 and up$216,720$64,548
Source: Vanguard: How America Saves

Broken down by age, the report states the following:

Given these figures, it’s pretty obvious you’ll need more than a 401(k) to enjoy a comfortable retirement. Still, taking advantage of the option is worthwhile, especially if your employer is matching contributions for those who choose to participate. 

That’s free money.

Investing Beyond Your 401(k)

As mentioned above, your 401(k) should be considered part of your retirement package, the other two being Social Security and personal savings/investments. This raises the question of how one should go about investing beyond maxing out the 401(k). 

For starters, noted financial guru Dave Ramsey recommends a Roth IRA, in which you can invest an additional $6k annually and the gains will be tax-free. This is because you pay tax on the money you invest with a Roth, rather than when you withdraw it. There are some limitations to consider, your annual gross must be less than $118k if you’re single or file your income taxes separately. Couples filing jointly must earn less than $186k annually. 

He also recommends taxable investments such as mutual funds and other traditional investment vehicles — assuming you’re debt free and have an adequate emergency fund.  Ramsey also discourages going into debt to invest. In most cases, the interest on the loan will be more than your percentage of gain. 

Alternative Investments

Diversifying your investment portfolio is one of the smartest things you can do. As tempting as it might be to put all of your assets into one hot-looking investment, your capital will evaporate if it fails to perform. Spreading your dollars around among less correlated assets helps minimize the risk factor. 

To that end, Yieldstreet, a leading multi-asset alternative investment platform, offers retail investor opportunities of the type previously reserved for institutions and ultra high net worth individuals. “All investors, here in the U.S. and around the globe, should have the ability to modernize their portfolios with investments that, until now, have been walled-off,” says Milind Mehere, founder and CEO of Yieldstreet.

With Yieldstreet, you can build a fixed-income portfolio spread across multiple asset classes with a single investment. High interest wallet accounts, real estate investment trusts and even fine wine and collectible automobiles are among the alternative opportunities you’ll find with Yieldstreet. 

Looking for a short-term investment that requires only a minimal outlay?  Yieldstreet has vehicles you can access with as little as $500 and commitments as short as three months. Additional alternative investment opportunities with Yieldstreet include supply chain, fine art and real estate. 

Whatever your goals after maxing out your 401(k) and investing beyond may be, you may find a Yieldsteet vehicle that will help you get there. Join Yieldstreet today.

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